What is it?
A stop-loss is literally a price (for the stock) at which you would like to stop your loss. In other words, this is the price beyond which you would not want to hold the stock anymore since that may mean further losses. The stop-loss order is made at the start of the trade and is such that it limits your loss on a particular security. A stop-loss order can be placed for a buy or sell (permitted only on stock futures) position and is used routinely by traders across financial markets.
How does it work?
A stop-loss order has to be placed at the time of taking the position, whether buy or sell. For example, if you are buying a stock at Rs 100, you can place a simultaneous stop-loss order at Rs 90 with your broker; that will ensure that as soon as the stock price touches Rs 90 in case of a correction, your stock will be sold and any further price correction will not add to your losses. Similarly, if you took a short position in a stock future or sold a stock future for Rs 100, your stop-loss price will be on the upside at say Rs 110 (a short position is in losses if the current market price is higher as the stock has to be bought back).
The price can be predetermined by doing a backward calculation of how much loss you are willing to accept. Some technical traders also use calculations based on the historical stock price volatility to ascertain how the price is likely to move and set a stop-loss based on these calculations. Either way, the stop-loss price is keyed into the original order placed with the broker and gets triggered automatically.
Who uses it and why?
While some say it is a critical discipline to use stop-losses for every trade, there are two reasons why traders like to use stop-loss prices. Firstly, it allows you to weed out all emotion. Buying and selling stocks or any other financial security can be very subjective and, hence, there is some emotion tied to it. Many a time, you may not be able to accept that you are wrong about your selection and hence are making a loss. In such cases, you will not do anything and the loss can get indefinitely extended. So setting a predetermined stop-loss price helps cut out emotions from a purely financial transaction.
Secondly, it could be that trading is a secondary occupation and you may not be able to dedicate your full time and attention. At such times, given that market movement can be sudden and sharp, it is better to have a predetermined stop-loss price in place to take care of losses in the event of unforeseen sharp movement.
What does it mean for you?
Knowing about stop-losses and understanding how these trades function is important for traders. However, for fundamental long-term investing, this is not so important. You should be aware though that sometimes when there is a sharp fall in markets, multiple stop-losses for traders get triggered automatically and lead to further selling in the stock. If you are a long-term investor, don’t get alarmed and exit the stock; revisit the fundamentals before taking a call to sell.